Behavioural finance: Why you invest the way you do and how to improve it

.Behavioural finance is an interdisciplinary field that studies of how people make financial decisions in the real world. One of the core focuses of behavioural finance is to identify the shortcuts (heuristics) and other mental quirks (biases) that affect people’s financial decisions, and how they can often go astray.

Behavioural researchers then look for practical, empirically tested techniques to overcome these obstacles, where possible. The field is simply fascinating and helps us both understand – and improve – our financial behaviour.

Our biases and their impact

Over the past three decades, researchers in economics and psychology have catalogued dozens of different biases that affect how investors make choices and cause them to deviate from their ideal economic outcome.

This work has challenged the common view in economics (and finance) that individuals are narrowly selfish and fully rational. In an investing context, these assumptions would have us believe that investors are all perfectly successful at maximising returns – they don’t make mistakes, they don’t let their emotions get in the way, and perfectly understand the markets. Anyone who has ever invested – and seen how other investors behave – know this isn’t true.

Psychologists Daniel Kahneman and Amos Tversky began their work on what is known as Prospect Theory in the 1970s. In a study, they found that people’s preferences for risk often depend on how options are described to them i.e. serious medical procedure with a 90 per cent survival rate elicits a very different response than one presented having a 10 per cent mortality rate.

Mathematically, they are the same, however.

Their insights, and those of other behavioural researchers, had broad implications for understanding human decision making, and its consequences for finance became clear right away. In a sample study, researchers found that a related bias causes an investor to hold on to losing stocks far longer than they should, to avoid realizing a loss (aka ‘the disposition effect’).

Researchers discovered numerous other biases that specifically affect financial behaviour as well, as such as illusory superiority (most investors think they are better than average), overconfidence (beliefs about oneself outpacing the reality), and recency bias (believing that past performance predicts future performance).Behavioural research like this has come to broad public awareness in the late 2000s with books like Nudge and Predictably Irrational, and Kahneman’s best-selling book Thinking, Fast and Slow.

Behavioural finance in the finance industry

For practitioners in finance, the wealth of research from the 1970s to today has increasingly seeped into practical work, especially recently. Ten years ago, Greg Davies, who set up one of the first applied behaviouralscience teams in finance, says “I had to start every single meeting with ‘has anyone heard of behaviouralfinance’…. I was often faced with reactions between skepticism and indifference.”

Now, behavioural finance is well known, and the interest is palpable. Michael Liersch, then Head of BehaviouralFinance and Goals-Based Consulting at Merrill Lynch, said, “I get so many calls a day from advisers, who are eager and excited… about behavioural finance.”

The intersection between behavioural finance and practice can be seen in terms of four distinct themes: cataloging investor biases, arbitraging market anomalies, developing tools to avoid and overcome these biases, and exploiting people’s biases for profit.

Much of the early work in the field – and a significant portion of the materials that practitioners develop and promulgate today – focus on cataloging and educating investors about their numerous biases.

The implicit or explicit assumption is that savvy investors, properly informed and educated about these biases, can overcome them. The effectiveness of this approach has been difficult to establish in the field.

Side by side with the study of individual biases, researchers and practitioners have investigated how investment mistakes might aggregate up into market anomalies such as asset price bubbles and crashes, the equity premium, and the small-cap premium.

A significant debate occurred, and continues to occur, about whether and how behavioural anomalies could persist over time, with some researchers arguing that limits to arbitrage, including trading costs and industry incentives, allow them to persist. The implication of such work is a potential for profit: if arbitrage is possible, well informed, behaviourally savvy investors might exploit these predictable irrationalities.

The third theme has only emerged in force over the last few years and focuses on developing tools to help individuals overcome their biases with ‘nudges’ or other techniques to change the decision-making environment for the better.

We’ve seen the most successful and prolific work in the field of retirement savings and investing, with examples like automatic enrolment, Save More Tomorrow, and facial age progression to help plan participants literally see their future selves and contribute more for retirement. There is also work on how to avoid biasing professional traders and non-professionals alike.

The fourth area of application is much more troubling, in that companies are effectively exploiting investor psychology to increase company profits at the expense of individual investors. Each time our industry encourages herd behaviour by hyping hot (or falling) stocks, uses complexity to impress and overwhelm unsuspecting clients, and buries fees in fine print (where behavioural friction means people won’t discover it), we’re exploiting these biases.

It’s not that these situations mean intentional deception or manipulation (though that certainly occurs); rather a key challenge is self-deception. Remember the term “illusory superiority”?

Just like most individuals’ investors believe they are better than average, we in the finance industry fall prey to the same challenge: few asset managers or advisers believe that their investing ability is at or below average.

And the same is true for each of the biases researchers have found; in the finance industry, we can deceive ourselves into thinking they don’t apply to us.

Beyond self-deception, exploiting investor psychology can be intentional: the tremendous research and effort used to push high-cost credit cards is one prominent case. In fact, guides exist to the darker arts of behaviouralscience, and how to push products regardless of the prospect’s interests, and conferences and events featuring ethically murky applications of behavioural research have also grown over the last few years.

Behavioural finance did not invent deceptive industry practices, but it both helps practitioners understand them and appears to be contributing to them as well.